Star’s trek: Company’s troubles don’t scare away big investors

One Friday last November, Star Scientific Inc. reported it had settled its decade-long patent infringement battle against the R.J. Reynolds Tobacco Co. for $5 million. It owed its lawyers about $2.2 million.

By the end of trading the next Monday, Star shares had dropped 27 percent. Having expected a big settlement, many investors apparently had lost patience with the Glen Allen-based company, which was losing tens of millions of dollars a year.

That was just the beginning of a string of bad news for Star.

In late January, the financial news website TheStreet.com reported Star “misled” investors regarding its relationship with a medical researcher at Johns Hopkins University, an allegation the company strongly denies.

In mid-March, the company disclosed a two-month-old investigation of company securities transactions by the U.S. Attorney’s Office for the Eastern District of Virginia.

On top of all this, Star’s CEO, Jonnie Williams Sr., became a key figure in another investigation by the federal prosecutor’s office involving Gov. Bob McDonnell.

In a series of stories beginning in March, The Washington Post revealed that Williams gave more than $165,000 in gifts and loans to the governor’s family and a family-owned real estate company in 2011 and 2012. First lady Maureen McDonnell used $30,000 of a $50,000 loan from Williams to purchase Star stock as an investment for the McDonnells’ children without the governor’s knowledge, according to a lawyer representing her. Virginia law does not require such gifts to be reported to the public.

McDonnell, who has recently returned the gifts and repaid the loans, asserts he has done nothing wrong and has given Star no special treatment. (See timeline.)

After trading at around $4.50 in August 2012, Star’s stock skidded to a closing price of $1.20 in May 2013, a slide that prompted a handful of investors to sue the company’s officers. Star’s troubles, however, have not scared away its biggest shareholders, some of whom have bought millions of shares through private placements and the exercise of warrants. Capital raised in these private sales has been crucial to the company’s continued operation, helping to fund research and pay bills as Star accumulated total losses of more than $240 million during the past 10 years.

After the string of bad news, shareholders welcomed an encouraging report on Aug. 9. The company said in a regulatory filing that it did not expect to be prosecuted as a result of any investigation by the U.S. Attorney’s Office. The stock price rose nearly 11 percent in the next two trading days, extending a gradual rebound since last spring.

A change in direction

Star executives declined requests to be interviewed for this report.

Founded as a discount cigarette and cigar manufacturer in 1990, the company has introduced a variety of products, including smokeless tobacco lozenges and smoking cessation products. In its long-running lawsuit against R.J. Reynolds, Star accused the giant tobacco company of infringing its patents for a curing process aimed at reducing carcinogens in tobacco smoke.

The company created Rock Creek Pharmaceuticals Inc. in Gloucester, Mass., in 2007 to explore the possible anti-inflammatory properties of alkaloids found in tobacco. Its first product was CigRx, introduced in 2010, which is designed to temporarily curb the desire to smoke.

Star discontinued production of its tobacco products at the end of last year to devote attention to products based upon a synthetic version of anatabine, an alkaloid found naturally in trace amounts in tobacco, peppers, green tomatoes, potatoes and eggplants.

One reason for the switch, Star said in filings, was the company’s connection to the tobacco industry hampered its efforts to interest medical research centers in conducting clinical research on the healthful properties of anatabine. The other reasons, according to the company, were declining sales and mounting operating losses.

Essentially, 23-year-old Star has turned itself into a biosciences startup.

Rock Creek produces Star’s main products: Anatabloc, a dietary supplement officially introduced at an August 2011 luncheon hosted by first lady Maureen McDonnell at the Executive Mansion in Richmond; and two cosmetics, Anatabloc Facial Crème and Anatabloc Facial Serum.The company says its Anatabloc dietary supplement, sold through 4,000 GNC stores, helps reduce inflammation and improve metabolism.
Company-sponsored research suggests the anatabine alkaloid may be able to help reduce the inflammation that accompanies many diseases, including multiple sclerosis, ulcerative colitis, Alzheimer’s disease, traumatic brain injury and thyroid disease. No independent research, however, has been done, according to the Richmond Times-Dispatch.

GNC named Anatabloc its top vendor of 2012 for product innovation in the wellness area. Sales of the dietary supplement were largely responsible for Star’s second-quarter revenue of $2.5 million, a level relatively unchanged from first quarter but up 74 percent from the second quarter a year before.

Shareholder lawsuits

While the company might not face charges from federal prosecutors, Star executives, including Williams; Paul L. Perito, the company’s chairman, president and COO; and several board members still must contend with shareholder lawsuits in federal district courts in Richmond and Alexandria, and two others in state courts in Richmond and Henrico County. (The company succeeded in consolidating seven separate lawsuits into four.) Some of the suits were filed in late March shortly after the company disclosed the investigation into its securities transactions.

These complaints allege Star Scientific misrepresented aspects of the company’s scientific research and misled investors regarding its future revenue prospects.

One suit, by investor Harold Z. Levine, filed in Richmond Circuit Court in July, attacks Star’s compensation of top executives. “These individuals have usurped millions of regular and bonus compensation as a result of their incompetent performance and deceptive activities,” the suit charges.

The company has said the salaries of its executives were pegged to those offered to counterparts in Richmond, Washington, D.C., and Boston.

During 2010 when the company lost $28.3 million on revenue of $63,000, the compensation of Williams and Perito totaled about $4 million apiece, including base salary, stock options and other benefits. In 2011, when company revenue climbed to $1.2 million and losses rose to $38 million, the value of Williams’ pay package was worth $9 million while Perito’s was $7.7 million, including nearly $8 million and $6.5 million in stock options, respectively.

Last year, with losses at $22.9 million on higher revenue of $6.2 million, Perito and Williams were not awarded stock options and their total compensation dropped sharply, to $1.3 million and $1.1 million, respectively, slightly more than their $1 million annual salaries.

Effective in January of this year, the company says, Williams voluntarily cut his base salary to just $1 a month and pledged to stay at that level until the company became profitable. Likewise, Perito cut his salary by $500,000 annually beginning in February.

In August, in its first public statement addressing all shareholder lawsuits, the company said in a regulatory filing its executives “intend to defend vigorously” against these allegations.

While no trial dates had yet been set for the suits, the company did announce that it is scheduled to face off against the Virginia Department of Taxation in court on Dec. 13-14.

Star and Virginia officials have been battling since 2002 over what the state says is an unpaid tax bill of more than $860,000. Star says it doesn’t owe the money because it was the result of an improper classification of its tobacco curing barns. With penalties and interest, the tax bill totaled $1.8 million as of June 30, the company said.

‘You have to keep fighting’

Star acknowledges its losses could continue indefinitely. Between April and June of this year, the latest quarter for which earnings information is available, Star posted revenue of $2.5 million and a loss of $8.7 million. That compares with a loss of $8 million in the same period in 2012. The higher loss was attributed to legal costs connected to government investigations and increased sales and marketing expenses.
Despite its continuing losses, an impressive list of major investors appears to have elected to stick with Star.

The list of largest institutional shareholders in August included Wall Street heavyweights such as Black Rock Inc., Bank of New York Mellon, The Vanguard Group Inc., Goldman Capital Management, Inc., State Street Global Advisors Inc., Northern Trust Global Investments, and the massive TIAA-CREF retirement fund.

A long string of losses is a risk that bioscience investors accept, says Jeff Gallagher, CEO of the Richmond-based Virginia Biotechnology Association.

“Five, six, seven, ten years of losses? I can immediately think of several different companies around the commonwealth that have gone through pretty much the same thing,” Gallagher says. “No profit in the first several years for a biotech startup is not really any sign of weakness. Sometimes there are not even revenues. It’s a common fate … You have to keep fighting.

“This is science,” says Gallagher. “You could be working on something for years and one day read in a scientific journal something that demands you look differently at what you’re doing, sometimes much for the better. It’s something people don’t think about … If it were easy, everyone would be doing it.”

Since at least 2004, Star has raised capital largely through private stock sales to a select group of investors, including wealthy individuals and investment management companies.

“The recurring losses generated by our operations continue to impose significant demands on our liquidity,” the company says in its latest annual report. “Over the last several years our liquidity demands have been met principally by private placements of our common stock and from the exercise of related warrants and stock options. In 2012 our company received proceeds of approximately $33.9 million through private placements and stock option and warrant exercises.”

From 2009 through 2012 the company raised $106.2 million in this manner. In addition to the $33.9 million in 2012, Star raised $19.5 million in 2011, $27.8 million in 2010 and $25 million in 2009.

U.S. startups often opt for private placements of stock rather than public offerings because private sales require less registration detail and usually cost much less.

One of the most active buyers has been Star’s largest shareholder, Tradewinds Investment Management LP, a hedge fund manager based outside San Francisco.
At press time Tradewinds Investment held 19 million shares or about 11 percent of all Star shares outstanding.

In late July, the investment company paid $4 million in executing warrants for 2.6 million shares after Star agreed to reduce the exercise prices by 10 to 17 percent.

The next largest shareholder with 8.7 percent of all outstanding shares was John Joseph McKeon, a private investor from Longboat Key, Fla., outside Sarasota. Late last year, according to company filings, McKeon executed warrants for 14.5 million shares.

(Efforts to reach Tradewinds executives and McKeon for comment were unsuccessful.)

Williams, the company CEO, was listed as the third largest shareholder with 9.8 million shares, while Perito, the chairman, president and chief operating officer, held 1.9 million shares.

‘Story stock’

What attracts investors to Star shares?

“This is sort of typical with startup companies in biotech and new health care,” says Wayne Wilbanks, who helps manage more than $2 billion as chief investment officer and managing principal at Wilbanks, Smith and Thomas Asset Management LLC in Norfolk.

“This is what I would call a ‘story stock,’ meaning that investors are buying into the hope that the company will one day bring in $30-, $40-, $50 million a year in revenue,” he says.

At the beginning of July, Star Scientific’s market capitalization, with 166.5 million shares outstanding, was $231.4 million. By mid-August investors on NASDAQ had valued the company at more than $330 million.
Normally, investors assign value to a company based on its annual earnings; but since Star Scientific has no profits, other metrics, like revenue are used instead.

“That’s a pretty incredible price-to-revenue ratio,” says Wilbanks, noting that Star’s market cap in July was 37 times its 2012 revenue. “You normally see that kind of market valuation on a company bringing in $15 million, $20 million, $30 million a year on a consistent basis, but not usually with a company with only single-digit millions in revenue.”

Wilbanks theorizes that “index buying” is most likely behind significant holdings by some of the biggest players in the world’s financial markets.

“I’d imagine that these companies hold it because of a general investment strategy to buy a piece of everything in the health-care field under $500 million [in market capitalization],” he says. “It’s not because of any strong fundamentals.”

The number of Star shares outstanding has climbed steadily from a little more than 77 million shares in 2006 to 166.5 million at the end of last year.

This doubling of outstanding shares during the past seven years has diluted their original value but also helped attract more individual investors who hope the low price they can afford to pay now will result in much higher prices in the future.

Issuing additional equity is a common fundraising strategy for companies that can’t afford the high rates of interest they would be charged on bank loans and bond sales.

In August, the company announced that it had $11.2 million in cash as of June 30, down from $23 million on Dec. 31. The company says that, if everything goes well, it should have enough money to cover its operations through March 2014. Nonetheless, it added a note of caution, indicating further private share sales might be necessary.

“However, our business and operations may consume resources faster than we anticipate, and depending upon market conditions and the price of our common stock, we may decide to seek additional funds before that time.”

Perhaps in anticipation of selling additional shares to keep the company afloat, the Star board at last year’s annual shareholders meeting approved expanding the total number of shares the company could issue from 207.5 million to 213.5 million.